A Sigh of Relief for Stocks

For major indexes, the worst is probably over in the near term. But further testing of the lows will be required down the road

From Standard & Poor's Equity Research

From Standard & Poor's Equity Research

Selling climax, capitulation, mini-crash, throw in the towel, massive intraday reversal, hammer formation. You name it and we had it on Thursday, June 8. The retest by some of the major indexes, after all of this volatility, was successful so far, so we do expect some movement back to the upside. With all the gyrations in stocks, bonds and crude oil were very quiet.

There are many interesting facets about Thursday's action. Trading volume was extremely heavy. NYSE volume came in at 2.56 billion shares, the third highest in the history of the NYSE. It was only surpassed by July 19 and July 24 2002, which corresponded to the first market bottom during the last bear market. Nasdaq volume was the fourth highest on record, at 2.9 billion shares. This was clearly capitulation-type volume that many times is associated with an intermediate-term bottom.

That this volume occurred during a massive reversal day, and near very important support, is a sign to us that, near-term, the worst is probably over. The one thing that worries us is that many times, maximum volume during bottoms occurs during the first low, and the second low sees less selling pressure. That may suggest that further testing of the lows will be required down the road, in our opinion.

The intraday reversal or hammer formation was the largest since July, 2002, which occurred fairly close to the major market bottom that month. When we measure the reversal, we are looking at the difference between the intraday low and the close. On the S&P 500, it was 22.75 points, or 1.8% above the intraday low. These type of intraday reversals were much more common during the 1990s when volatility was higher. They have been quite uncommon over the past couple of years. In our view, the faster the market corrects, the faster it can trace out a bottom.

The S&P 500 hit an intraday low of 1235.18 on Thursday, below the previous intraday low of 1245.34 on May 24. Because of the reversal, however, the index was able to close at 1257.93, very close to the recent low closes in May and early June. Therefore, on a closing basis, the S&P 500 once again successfully tested the recent lows.

Another key to Thursday's action, in our view, was where the index found support and reversed to the upside. A key trendline drawn off the August, 2004, and October, 2005, lows came in at 1239 on June 8, very close to the intraday lows. This trendline is key for a couple of reasons. First, it has provided support for the market for a fairly long time. Second, it has been the floor for the bull market and a substantial break of this trendline would raise serious doubts, in our view, about whether the market is still in a bull market.

In addition to this important trendline, a key moving average also provided intraday support on Thursday. The 65-week exponential moving average was at 1243 on Thursday. This average has worked well over the last couple of years, providing good support during the August, 2004, April, 2005, and October, 2005 lows. Like the trendline we just talked about, a strong break below this moving average could signal a reversal in the bull market that started from the bottom in October 2002.

To confirm that a bottom is in, and that the worst is over, we would like to see a couple things develop over the next couple of weeks. First, we would like to see at least one day, preferably multiple days, of very strong price gains (1% to 2%) on above average volume. Second, we would like to see the S&P 500 close above the recent interim closing high of 1288. If this were to occur, then a double bottom will be confirmed and then more upside could then be expected, in our view. Third, we would like to see some leadership emerge, preferably from the groups that were leading before the latest pullback.

Longer term, we still believe the market is susceptible to a major correction or bear market this year. We were looking for the major damage to occur later this year, in the third and fourth quarter. If the current pullback were to morph into a 10% correction for the S&P 500, then it would be rare to then rally, and then move into a bear market later this year, in our view. A 10% correction right now would possibly mean that the index has moved into a wide trading range that may last eight to 12 months, where the bottom is tested multiple times. Either way, the intermediate-to longer-term view is not great in our opinion.

Long-term sell signals have not been generated yet, in our view. These are based on long-term moving averages as well as long-term momentum indicators. The 10-month exponential moving average remains above the 20-month average. The 20-month sits at 1226 and has provided a floor for the S&P 500 during most of the bull market. The 17-week exponential moving average remains above the 43-week average. Remember, though, these crossover systems give very few signals, and because of their length, are not good at getting you out, or back in, extremely close to major turning points. They can, however, keep you out of trouble for major bear markets, and keep you in for the majority of a bull market. The monthly moving average convergence/divergence (MACD) has started to roll over and is very close to crossing below its signal line. The last sell signal from this momentum indicator was back in early 2000 while the last buy signal was in May 2003.

Market sentiment continued to move towards the bearish fence, and eventually, we believe this is a positive. The CBOE put/call ratio hit an extreme reading of 1.36 on Thursday. The CBOE P/C ratio has seen readings of 1.00 or above on 15 of the last 19 trading days. Not only is this a very high frequency of 1.00+ readings, the absolute levels of P/C's has been extremely high. The range over the 19-day period has been 0.75 to 1.52 and the 19-day average of those readings is 1.16, an all-time record.

The American Association of Individual Investors (AAII) has seen bullish sentiment drop to only 30.8%, and bearish sentiment rise to 50%. This is the most bearish that this survey has gotten since April 2005. Investor's Intelligence poll is showing only 40.2% bulls, the fewest since August 2004,while bearish sentiment has climbed to 31.5%, which is near the highs over the last three years.